Plan to Change Canada’s Tax Avoidance Rule Raises More Questions

In its latest federal budget, released March 28, the Canadian government introduced significant legislative amendments to the general anti-avoidance rule. The rule applies when three requirements are met:

There is a tax benefit;
There is an avoidance transaction (that is, a transaction undertaken primarily for tax purposes); and
The avoidance transaction, or the series of transactions of which it’s a part, results in a misuse or abuse of the relevant tax provisions or the legislation as a whole.

The government has proposed to introduce a novel preamble to the GAAR, a modified threshold for identifying an avoidance transaction, and a new “economic substance” test to be considered in the determination of whether there is misuse and abuse.

A New Preamble

The proposed legislation contains an introductory provision aimed at addressing interpretive issues and ensuring that the GAAR applies as intended.

The preamble recognizes that taxpayers are free to arrange their affairs to obtain tax benefits intended by Parliament; however, they can’t misuse or abuse the tax rules to obtain unintended benefits. It also states that the GAAR strikes a balance between taxpayers’ need for certainty in planning their affairs and the government’s responsibility to protect the tax base and “fairness” of the tax system. Finally, it clarifies that the GAAR can apply regardless of whether a tax planning strategy is foreseen.

The proposal specifies that fairness in this sense is intended to be interpreted broadly, “reflecting the unfair distributional effects of tax avoidance as it shifts the tax burden from those willing and able to avoid taxes to those who are not.”

The proposed preamble is partially in response to Canada v. Alta Energy Luxembourg S.A.R.L. In that case, the majority of Supreme Court of Canada ruled in favor of the taxpayer and observed that the GAAR was enacted to address unforeseen tax strategies. Because the tax strategy at issue in Alta Energy not only was foreseen but also encouraged by the relevant provisions, it’s debatable whether a provision like the preamble would have caused a different outcome.

A Modified Definition

The proposed legislation also changes the standard for determining whether a transaction is an avoidance transaction. That’s defined as a single transaction (or one that is a part of a series) where the transaction (or the series) results directly or indirectly in a tax benefit, unless the transaction is carried out primarily for non-tax purposes.

The proposal would replace this primary purpose test with one based on whether one of the main purposes of a transaction (whether alone or as part of a series) was to obtain the tax benefit.

The stated purpose of this change is to ensure consistency with the standard used in many other modern anti-avoidance rules. The intended result is for the GAAR to apply to a transaction with a “significant tax avoidance purpose” but not to one where tax was simply a consideration.

A New Test

Finally, the proposed legislation introduces a new economic substance test in the misuse and abuse element of the GAAR analysis. This measure is stated to be in response to GAAR jurisprudence that, according to the government, has established a more limited role for economic substance.

Specifically, in Canada Trustco Mortgage Co. v. Canada, the Supreme Court observed that in the GAAR context, the concept of economic substance “recognizes that the provisions of the [Tax Act] were intended to apply to transactions that were executed within the object, spirit and purpose of the provisions that are relied upon for the tax benefit.” The court also clarified that under the GAAR, a transaction doesn’t result in “abusive tax avoidance merely because an economic or commercial purpose is not evident.”

The proposed new test doesn’t require an inquiry into what the economic substance of a transaction is but itemizes at least three factors that, in the government’s view, tend to indicate a lack of economic substance. They are:

Whether there is the potential for pre-tax profit;
Whether the transaction has resulted in a change of economic position; and
Whether it’s reasonable to conclude that the entire, or “almost entire,” purpose for undertaking or arranging the transaction or series was to obtain the tax benefit.

The proposal indicates that an avoidance transaction that is “significantly lacking” in economic substance “tends to indicate” that a transaction or series results in a misuse or abuse.

As proposed, the new test is problematic because it’s situated at the wrong stage of the GAAR analysis—the question of whether a transaction is primarily tax motivated rather than primarily commercially motivated is relevant in determining the existence of an avoidance transaction, but it’s now proposed to be at the misuse and abuse stage.

Despite the breadth of the potential changes, the proposal clarifies that a lack of economic substance won’t always mean that a transaction is abusive. It will still be necessary to examine the policy of the relevant provisions to determine whether there has been a misuse or abuse. It also confirms that existing jurisprudence will remain relevant when a transaction has economic substance.

It remains to be seen whether subjective terms such as “significantly lacking,” “tends to indicate,” and “almost entire” will be retained in the final legislation following the consultation period and, if so, how the courts ultimately will interpret such concepts.

Closing Observations

To date, the GAAR has operated effectively in striking a balance between achieving certainty in tax planning and countering tax abuse. While it’s clear in light of the proposal that certain changes to the GAAR are inevitable, it’s hoped that all of the proposed measures won’t be introduced in their current form.

The new rules, and particularly the proposed new economic substance test, are otherwise likely to cause significant uncertainty in tax planning.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Pooja Mihailovich is a partner in the tax group at Osler, Hoskin & Harcourt LLP. She specializes in tax litigation and dispute resolution.